The Fed Needs to Step Up and Do More

The bond-buying program continues, but it's not enough

The Federal Reserve has decided to continue its $85 billion-per-month bond purchase program for now. This was the word from the October policy statement, a decidedly low-drama event after September’s surprise “no taper” decision.

Bernanke and co., who seemed so ready to pull back on the cheap money stimulus over the summer as the bond market got frothy and the economy firmed, are now pulling back from that sentiment. Any tapering seems unlikely before early 2014 — when the Fed will see new leadership from vice-chair Janet Yellen. (Bernanke, like Alan Greenspan before him, has impeccable timing getting out now before the tough decisions must be made.)

In their statement, Fed officials highlighted their concern over the big drop-off in housing activity after 30-year mortgage rates blasted from 3.4% in May to a high of 4.6%. Pending home sales dropped 6% month-over-month in September, nearly 2% in August, and have fallen for four consecutive months. On a year-over-year basis, pending sales are down 1.2% for the first negative reading in more than two years.

Other areas of the economy are weakening as well. Consumer sentiment hit a six-month low. Core durable goods orders are stalling at the second-weakest pace since the recession ended. Business inventories are swelling, pulling down Q4 GDP growth estimates to just 1.6%, according to macroeconomic advisors. While that means QE will continue short-term, it also casts increasing doubt on the ability of cheap money stimulus to encourage real economic growth (which is the problem the Japanese are suffering from).

Just look at the disconnect between QE3 and oil prices — we’re in a liquidity trap. Growth of monetary aggregates, such as M2, also continue to fall off. That’s not good, and it means the Fed has no easy out. Clearly, the ongoing QE3 program is losing efficacy. But merely the hint of stopping it slammed the brakes on the central area of the economy: real estate.

The best thing, in my mind, would be for the Fed to inject funds directly into the economy by funding public-private infrastructure investment trusts or finding a way to convert its U.S. Treasury holdings from debt to equity-like assets — effectively wiping away some of the national debt. As I’ve written before, this could be done by converting long-term Treasury bond holdings into zero-coupon perpetuity bonds or something similar.

In other words, the Fed needs to do more, and do it more aggressively and creatively than it is now. It’s not enough that it has taken the monetary base from $800 billion pre-crisis to nearly $3.7 trillion now.

Because the worst thing it could possibly do would be to tighten liquidity now, with inflation well below its 2% target, as personal-consumption expenditures drop to a pace that matches or falls below the levels seen during every recession since 1960. A debt deflation recession would be a Japanese-style nightmare, since falling prices or low inflation increases the real burden of debt.

But we’re running out of time. The Federal Reserve Open Market Committee is much more dovish now than it will be next year as a number of dovish governors retire and more hawkish regional bank presidents rotate into voting positions. Both of the most hawkish regional Fed presidents will be voting FOMC members next year: Philly Fed president Plosser and Dallas Fed president Fisher.

Deutsche Bank analysts see an even split between hawks and doves next year; a big swing from where the FOMC is on policy now. Combined with the untested leadership of the first female Fed chief, and we could see much more dissent and perhaps an earlier-than-expected and more vigorous taper of QE3 starting in March.

Already, the markets are frowning on the Fed’s removal of language about “tightening conditions” in the financial system. So the sensitivity to any Fed pullback is extremely high.

A more hawkish stance in 2014 would rattle complacent, bubbly markets and shake investors out of their dream-like, “buy everything at the high” mindset. Buckle up — the next few months are going to be exciting.

Stocks are selling off on apparent disappointment that the Fed wasn’t expanding QE3. I’ve recommended clients start looking at opportunities on the short side including Tesla Motors (TSLA) and Trina Solar (TSL). I’ve added both to my Edge Letter Sample Portfolio.

Disclosure: Anthony has recommended TSLA and TSL short to his clients.